Imperfect Competition

We have now looked at the two poles on the market power spectrum - the monopolist and the perfect competitor - and it should be pretty clear at this time that given the choice, a firm would want more rather than less market power.  As a monopoly Tammy was able to extract some economic profit from the tutoring business, something she could not do in a perfectly competitive environment.  Tammy was the only seller and could therefore choose price without concerning herself with the behavior of other sellers.  Under perfect competition, Tammy had no influence over the price and any competition was on the cost side of the income statement. 

Often times, however, we find ourselves somewhere between the two poles of the market power spectrum.  In this section we will look at monopolistic competition and oligopoly, two models of behavior that occur between these two poles.  By extending our analysis beyond the poles we will be better able to understand a number of 'real' world situations.  Once we move into this more realistic range on the market power spectrum, we will find there are two "secrets to success" in business - the reduction in costs and the differentiation of product.   In this unit we will discuss one of these - the issue of advertising and product differentiation.

Monopolistic competition, as the name suggests, refers to a market structure which is a blend of the two polar cases.  It shares with competitive firms the assumptions of many sellers and buyers, freedom of entry and exit, and perfect information. Where it differs from the competitive model is these firms are facing downward sloping demand curves because they have managed to differentiate their own output and are not selling a homogeneous product.  Firms are not all selling fast food, gasoline, or T-shirts, they are all selling variations that are viewed by the consumer as good, but not perfect, substitutes.  

In the case of tutoring, you would expect to see a large number of sellers of tutoring services. What are the implications of the assumptions?  The decision rule is still the same, Tammy will make her choices guided by the decision rule MR = MC.   The left-side diagram below is a picture of the situation in the short-run.  Profit is being made by Tammy as long as AC < P (left-side diagram). If a profit is being made by Tammy, others will enter the business which will lower demand for each firm as they split the market amongst more sellers.  When McDonald's opens in a neighborhood, it is no accident that Wendys and Burger King often follow, and they end up dividing up the market and leaving each with fewer customers. Entry will lower the demand and MR curves and this process will continue until profits have been eliminated (right-side diagram).  We have zero profit, which is what we had in the perfectly competitive model.

How do the consumers fare in this world?  What do the students get in the tutoring market?  What they get is output that is more costly than it would be in a competitive environment. In the right-side diagram the optimal output level is to the left of the minimum AC which means there is an inefficiency here and the firms are operating with excess capacity. While each firm is behaving optimally, the result is not optimal from society's point of view when viewed on a cost basis. 

But the students do get something for the excess capacity and additional cost. They get variety which comes with product differentiation, and there are often benefits that come with differentiation.  Caterpillar heavy machinery has been successful by differentiating itself through the service network that comes with its equipment, something that would be crucial to many construction companies not able to afford down-time.  Nordstrom's has carved out a very successful niche in the crowded Department Store market by providing in-store services that others did not.  Miller beer was able to jump quickly from seventh to second in the beer market by differentiating its product, by changing its image from the "Champagne of beers" to Lite beer that appealed to the traditional beer drinking population. 

How are products differentiated?  What is the difference between Tammy's Tutoring and all the others providing tutoring services?  There are many ways that Tammy could distinguish her service?  A good place to start the search would be the barriers to entry that were mentioned at the beginning of our discussion of imperfect competition.  Tammy could have the key spot on campus that sets her tutors apart?   Her tutors could do "house calls" and meet students in their rooms, or she could have extended hours of service.  She might offer guarantees tied to improved performance, or she might have a better advertising program.

Economists have been split on their assessment of the value of advertisement, although we can certainly see how it could be a very important tool for a firm trying to differentiate its product.  On one side we have those who see advertisement as a bad, as economically wasteful and simply adding an additional layer of cost to the price of goods and services.  It also acts as a barrier to entry, reducing competition in markets.  It is also viewed as manipulative and misleading and weakening the power of consumer sovereignty, a concept at the heart of the conservative view of the market system ideal. In that perfect world, individuals would have "real" wants and needs and firms would emerge to satisfy those needs.  In the world of large scale advertising, the individuals are told what their wants and needs are by the companies - a concern raised years ago by John Kenneth Galbraith in his books The Affluent Society and The New Industrial State.  

On the other side there are those who believe that advertisement enhances competition and reduces the search cost for consumers.  In support of their position, they point to a few studies that have looked at advertising.  In a rather dated study of prices across 100+ plus industries for a 14 year period, they find that industries with higher than average expenses had lower than average price increases.  More recently there was a study of eyeglass prices and the prices were found to be substantially lower in states that allowed advertising.  A study of the toy industry suggested that TV advertising brought down the costs of children's toys.  The national advertising brought down the costs of doing comparison shopping and it resulted in toys  moving off the shelves faster which reduces costs. 

It is unlikely that the issue of advertising's impact on economic efficiency will be resolved, but there is no question it is a key element in a firm's effort to differentiate its product.  There is also no clear "verdict" on the valuation of monopolistic competition.  On the plus side is the fact that consumers get variety, something that may not be fully appreciated until you consider a world without choice.  On the negative side is the existence of excess capacity and a price somewhat above the minimum cost.  Now we will turn our attention to our second model of market structure, oligopoly.

Oligopoly, the name given to markets where there are a few big players, is near the other end of the market power spectrum. This is where we talk about Big Business, about competition, about strategy, about massive advertising campaigns. This was missing in our discussion of monopoly since there were no competitors; it was missing in our discussion of perfect competition since price was the only factor affecting demand; and it was missing in our discussion of monopolistic competition since the firms were smaller and made less profit.

The difficulty with oligopoly is that there is no 'ONE' model of oligopolistic behavior because the mutual interdependence of the individual firms can take on many forms, each of which has a different implication for behavior.  One oligopolistic industry may be dominated by a firm that seems to set prices others follow while another may be one where all competitors tend to follow price increases but not price decreases.  For this reason we will not attempt to survey the many and varied models of oligopolistic behavior, but rather focus on a few important concepts that have emerged from the study of oligopoly.  

One such concept is contestable markets.   A very real concern with oligopoly is the lower output and higher prices that are expected from firms with this type of market power.  You know that Tammy, in her relentless pursuit of profit, will stick it to the students if she can.  The power of oligopolists could be moderated, however, by the fear of potential competitors.  If there were freedom of entry, then oligopolists would not be able to raise the price above a competitive price without risking the entry of competitors.  If the competitive price of tutoring was $7 an hour, Tammy would be able to maintain her monopoly as long as she kept the price below that level.  Once the price rose to $7.20, Tammy would find other tutoring services entering because of their belief that they could make a profit.  Another  example would be the garbage service in a city.  Although a city usually signs an agreement with a company giving it the market, if a firm charged excessive prices, then it would likely lose the contract in the future to a competitor.  The weakness of this argument is the assumption of freedom of entry and exit, the assumption that entry and exit are costless.

One thing that does emerge from the oligopoly model is the importance of strategic behavior.  To demonstrate the situation facing monopolists, let's look at a variation on a classic example - the prisoner's dilemma.  This is one of the most widely know examples of what has become known as Game Theory. In recent years economists have turned to game theory to gain insight into the behavior of oligopolists.

We'll use Tammy's Tutoring to demonstrate the basics of the game.  Let's assume Tammy has a small group of competitors that tend to behave in a similar fashion.   The decision Tammy is facing is a pricing decision - to raise or not to raise the price.  The problem for Tammy is she does not know what the other tutor services will do, but she is confident they will either raise or lower the price.  The four possible scenarios are presented in the table below.  The numbers in the cells represent estimates of the change in profit associated with each possibility.  If you read across a row you are looking a the implications of a decision made by Tammy.  The first row describe what will happen if Tammy lowers her price.  The columns correspond to the decisions made by the competitors.  The first column describes the impact of the competitors' decision to lower price.  The question here is: what is the optimal strategy? 

The Pricing Decision

There are a number of possibilities that depend upon the preferences of the players and the rules of the game. For example, a player who very much liked risk would most likely have a strategy that was different from one who was risk averse.  The behavior of the players would also be different depending upon the frequency of the game - a game played once would likely result in a different solution than one played many times.  If you are interested in this type of work, you would definitely want to look more closely at game theory.

One option would be a maximin strategy, to make a choice where the minimum payoff is maximized.  In this situation, if Tammy adopted the maximin strategy she would choose the lower price strategy.  By choosing that strategy, Tammy would gain $20 if the competitors raised their price, and she would lose $100 if they lowered their price in response to her lowering of the price.  This is superior to the raising price strategy since this could lead to a loss of $200 if the competitors lowered their prices.  

If you look closely at the table, however, you may see something this fact was not lost on Tammy. Before you read on, go back and see if you can see a better option.  To the budding entrepreneur it is hard to pass up that $100 for each participant if they both raised prices. This will clearly give the sellers the most money of all the options (+$200). The problem is it is also the riskiest strategy if there is no cooperation.  

But if the reward were substantial enough, you would have the very real possibility of some cooperation.  When the oligopolists, acknowledging their interdependence, attempt to coordinate their actions so they act as a monopolist, we have what would be called a cartel. It is easy to see the gains from acting as a monopolist.  And the gains can be huge as we saw in the 1970s when OPEC, the Organization of Petroleum Exporting Countries, restricted output driving up the price of oil and creating enormous wealth in the oil exporting nations. 

Why is it we have so few examples of cartels if they are so profitable?   Why do students not have to worry too much about the formation of a cartel?  To understand why students can rest comfortably, let's look at the requirements for a successful cartel.   For a cartel to be successful the participants must be able to raise the price substantially.  This requires a low elasticity of demand  and a low elasticity of supply of non-cartel members.  The first of these means a restriction in output will increase price substantially as people will pay what they have to obtain the reduced output - something we looked at earlier in the elasticity section.  A low elasticity of supply of non-cartel members, meanwhile, means an increase in price will not prompt non-cartel members to increase their supply, which would lower the ability of the cartel members to raise their price. 

There also has to be a low expectation of punishment which is certainly not the case in the US where cartels are illegal.  It is also important to have low organizational costs which we are likely to see when the industry is dominated by a few firms selling undifferentiated products and when active trade associations exist.  Firms should also have small incentives to cheat which is likely to happen when they face steep MC curves and when fixed costs are low. The limited incentive to cheat if the MC curve is steep is due to the fact that any increase in output (cheating) would raise costs sharply and thus the profit from expanding would be limited.  A high level of fixed cost on the other hand would give firms a real incentive to raise output since variable cost is likely to be small and the additional revenue could help cover the substantial fixed costs. 

Fortunately these conditions are not often satisfied.  In practice it is difficult to organize cartels and even more difficult to control them as OPEC ultimately found out in the 1980s. The 'structural' flaw in the cartel is that there is a divergence between the optimal decision for the individual seller and the entire cartel.  For example, if you were one seller in a market, you would want to see all sellers restrict their output, which would drive up the price. You would then want to raise your output, which was not large enough on its own to affect the market price, and earn higher revenues from the additional sales. The problem is everyone looks at it the same way and thus the cartel is likely to collapse as the members pursue their own optimal strategy. Finally, there is the legal issue - the US government tends to dislike cartels and it outlaws any open collusion.

In the situation at RIU, Tammy and the competitors clearly have an incentive to collude and raise price which they will be able to accomplish only if they restrict output (downward sloping demand curve). Once all of the competitors agree to restrict output, Tammy has an incentive to cheat - to raise the number of hours she supplies and sell them at the higher price.  But everyone else sees the logic of this choice and quickly you will see the growth of cheating that will result in an increase in output and lower prices.  The cartel fails and the students win.

There are, however, strategies that can increase the likelihood of a cartel's success.  The firms could agree to divide up the market and establish market shares.  They could also use most-favored-nation clauses, where all buyers are guaranteed the lowest prices, and the meeting-the-competition clause, where each seller agrees to match the buyers best price.  In the latter case, if a cartel member attempts to undercut price, word will get out very quickly.  

While open collusion may be rare in the US, there is the possibility that firms engage in tacit collusion - they engage in behavior that would is consistent with collusion without ever formally meeting or agreeing on a plan. One form for this behavior would be price leadership - the players in an industry decide to allow one firm to set prices and they follow suit. One example would be the airlines when they cut the commissions paid to travel agents.  After Delta announced the cut, the largest airlines matched it.  Tammy could certainly take the price leadership role on setting prices and all other suppliers would fall in line.  

It is now very obvious that profit acts as a magnate for resources and there are some very real benefits to market power.  In the next unit we will look at how the government has gotten into the action through the direct regulation of industry and its antitrust laws.